The Best Sources of Working Capital for Your Small Business
Excelsior Growth Fund (EGF) works with small business owners who need more working capital – the funds needed to cover day-to-day and shorter-term operational expenses – for a variety of great reasons: they’re start-ups ready to launch and grow, existing businesses positioned for expansion or seasonal businesses.
EGF finds there are two common mistakes that small business owners often make when seeking working capital financing. First, businesses sometimes use a short-term loan such as a line of credit, which is traditionally paid off in under 12 months, to fund longer term expenses (e.g. equipment purchases or leasehold improvements) that can be associated with expansion or startup operations. The short term repayment schedule can put a strain on a company’s cash flow if repayment is due before increased revenue and profits are fully realized.
Second, sometimes businesses experience a financial pinch because they have not secured enough working capital to support their business during its startup or growth phase. Business owners may overestimate revenue or underestimate expenses and find themselves short of funds. When that happens, a lack of working capital may result in missed opportunities – there’s not enough money to bid on a project, hire more employees, get a better deal on inventory, or purchase advertising. At worst, insufficient working capital can lead to late payments to vendors and creditors, damaged credit scores and even loans from predatory lenders.
With that in mind, this article explores assessing working capital needs and potential sources for securing that capital.
How much working capital does your business need and how long will you need it?
The first step to getting sufficient working capital is to figure out how much financing you need and how long you need it.
Short-term working capital needs (less than 12 months) frequently result from business seasonality – for example, purchasing inventory for peak selling seasons. These needs can also relate to fulfilling new contracts – such as purchasing materials or equipment or adding staff – and the need may be compounded while waiting for payments on the contracts.
Short-term working capital needs like these are best served by short-term loan products such as lines of credit. Typically, lines of credit provide a maximum amount of borrowing for a set period (12 months) based on a company’s inventory and receivables. Funds can be drawn down and repaid, depending upon the business cash flow, throughout the commitment period with the borrower paying interest only on a monthly basis. The lender typically requires principal to repaid in full at least annually. Generally, there is no prepayment premium.
Working capital needs that extend for longer than 12 months are common for start-ups or the expansion of existing businesses. Start-ups need working capital for things like hiring staff, professional fees and filings, and anything else specific to getting a business up and running. For start-ups, it’s also wise to have 6-12 months of operating expenses available – and 12-18 months is ideal – to ensure there are sufficient funds available as business operations get underway, and while a business works towards becoming profitable. For existing businesses, it’s advisable to have sufficient funds to cover at least 3-6 months of operating expenses to address slow periods. For existing businesses undergoing expansion, they may have working capital needs similar to start-ups due to the addition of staff, increased inventory needs and other increased overhead expenses.
Longer-term working capital needs like these are best met by equity investment or term loans with longer repayment periods. This is commonly referred to as permanent working capital. A typical term loan for permanent working capital can range from 3 – 7 years depending on the lender. Monthly payments of both principal and interest are made by the borrower over the loan period.
Sources of working capital for small businesses:
There are several sources of working capital available to small businesses. Options can vary based on years in business, owner creditworthiness, industry, and other factors. Note that there are loan options that specifically support start-ups, underserved communities and more.
Vendor and trade sources:
The most common sources of short-term working capital for inventory purchases are credit terms offered by vendors. For start-ups, this may be difficult to negotiate, as vendors may require cash-on-delivery (COD). But once you have established vendor relationships, try negotiating longer payment , which gives you time to turn over inventory and have more cash on-hand. If you need money to make equipment purchases, try to find vendors who offer financing programs. While the interest rates might be higher than traditional bank financing, this can still be a good option. Be sure to do your homework to ensure you’re getting a good deal. Seller offered financing should always be compared with financing available from other sources. Finally, if you have accounts receivable, you may be able to reduce ongoing working capital needs by offering early-payment discounts to customers who meet the terms that you set (e.g. paying you in 10 days results in a 2% savings to the client while you receive your money in 10 days, rather than 30). Although you’re offering a discount, having cash available sooner can be lower than the cost of borrowing against a line of credit.
If you qualify, commercial banks and credit unions are the most affordable sources of working capital. As a small business owner, it’s wise to develop a relationship with a loan officer at the bank that has your commercial account. Loan officers can advise about what’s available, as well as the likelihood of approval. Even if you only receive a small line of credit or loan to start, you’ll build your business credit history and add to your available cash flow. These lenders are often reluctant to finance businesses with less than two years of operations, though, so start-ups are less likely to get approved early on. Still, EGF recommends establishing these relationships anyway, as they’ll be invaluable down the line.
Another way that some small businesses leverage bank relationships to improve working capital is through overdraft agreements. Like loans and lines of credit, these agreements are negotiated in advance. However, once in place, they enable businesses to essentially ‘borrow’ limited amounts as needed, without penalty, though the interest rate tends be high, similar to a credit card.
Lenders offering United States Small Business Administration (SBA) loan programs and alternative community lenders like community development financial institutions (CDFIs) are also great sources of working capital for small businesses, including those in the start-up or early phases with little financial history; for owners with less-than-perfect credit; for businesses in industries that traditional lenders consider too risky; for businesses with limited or no collateral; or for owners or businesses in traditionally underserved communities.
SBA loans aren’t actually made by the SBA; instead, the SBA provides loan guarantees to traditional lenders and other funders, like CDFIs, to encourage lending. For more information on specific loans, like SBA Community Advantage and 7(a) loans, see this.
CDFIs (like EGF) are non-profit, mission-driven organizations that typically offer loans to borrowers unable to secure bank financing and at more attractive terms than other alternative financing options. They provide small business owners with manageable payments to keep more working capital on-hand for growth and are great resources, too, especially for early-phase expanding businesses.
Alternative cash flow lenders and merchant cash advance services:
Other funding options that can appear attractive to small business owners – but that should be approached with extreme caution, if at all, and EGF does not recommend them – are aggressive online lenders that base lending decisions on incoming merchant receipts and daily bank deposits.
While these lenders offer quick and easy applications and access to fast cash, the money comes with exorbitant interest rates. Effective annual percentage rates (or “APRs”) of 50% or more are common. Also common are rapid repayment terms, often requiring daily withdrawals from your bank account. Before long, most small business owners find these terms burdensome, putting their business at risk. (For an example of how a small business owner got caught in the predatory lending trap before working with EGF, read this.)
And remember - never fund a longer term working capital need with one of these rapid-repayment loan products!
If your business could use a working capital boost, contact EGF’s Business Advisory Resources team for guidance. Even if you don’t qualify for traditional bank financing, EGF has quick and affordable longer-term loan options available, as well as educational services and broad community networks to help you get the funding you need to support your small business’s success.
About Excelsior Growth Fund
Excelsior Growth Fund (EGF) helps businesses in New Jersey, New York and Pennsylvania grow by providing streamlined access to business loans and advisory services. EGF’s signature product, the EGF SmartLoan™, provides up to $100,000 in fast, transparent, and affordable financing through a secure online platform. Larger loans up to $500,000 are also available. EGF is a nonprofit organization and is certified by U.S. Department of Treasury as a Community Development Financial Institution (CDFI). Learn more at www.excelsiorgrowthfund.org.